By Steven PinchukUnfortunately, the term “profit optimization” is often incorrectly used to describe a variety of applications, including data storage and retrieval, query and reporting, and basic descriptive statistics - none of which actually offer any type of optimization capability.

Published: 20 Oct 2008

By Steven Pinchuk

Unfortunately, the term “profit optimization” is often incorrectly used to describe a variety of applications, including data storage and retrieval, query and reporting, and basic descriptive statistics - none of which actually offer any type of optimization capability.

True profit optimization provides recommendations derived by mathematically balancing resource and demand constraints to achieve the lowest possible cost or highest possible revenue. Optimization techniques require sophisticated analytical tools and complex mathematical algorithms, as well as the ability to process large amounts of data. Without these algorithms and analytical tools, software vendors that describe their capabilities as “optimization” are not actually able to accomplish this sophisticated and valuable process. Because of this inaccurate overuse of the term, many managers have become desensitized to the entire concept, without actually being introduced to the real benefits.

Total demand profit optimization is the process of optimizing revenues by managing all functions within the organization that generate demand and affect profits. It considers not only total demand for each product at each price, but also the value of the organization’s customers and the costs of marketing to and booking these customers. This process has its foundation in revenue management, but extends the capabilities to include marketing, pricing and distribution functions.

Revenue management
Revenue management is the science of maximizing revenue by determining the optimal mix of products and prices that the organization should offer. Revenue management was conceived by the airline industry after deregulation to solve the problems faced by capacity-constrained firms with time-perishable inventories and multiple streams of different-value demand. As firms realize the advantages of proactively controlling sales to maximize profits, the application of these techniques is spreading throughout the travel and hospitality industry and beyond. Revenue management systems maximize revenues in three ways: minimizing the displacement of high-valued guests, establishing network controls to ensure revenue is maximized over the entire period, and overbooking to protect against no-shows and cancellations. Demand for each product from each relevant segment of customers is forecasted, and then optimization algorithms are applied to the demand forecasts to generate the optimal mix of prices and products.

Applying revenue management typically generates revenue increases of four to eight percent, but it is not without its weaknesses. Traditional revenue management optimizes demand against a fixed and pre-established set of prices, without considering whether that set of prices represents the customers’ willingness to pay. Further, the marketing department does not typically have access to forecasted demand patterns generated by the revenue management system as they plan promotions and initiatives.

The next generation of revenue management solutions will integrate and synchronize all of the activities that generate demand and affect profits across an organization, including revenue optimization, customer relationship management, marketing planning and execution, distribution and pricing strategies. Resource constraints, at all levels from all functions, are balanced against the profitability upside of each potential decision until the optimal set of decisions that maximize overall firm profitability are achieved.This complex solution, known as total demand profit optimization, involves advanced analytical tools tightly integrated with business rules and processes.

Whether promoting safety or increasing loyalty, integration counts
Each time the US military executes a campaign, they need a single interface that lets them see the actions of separate departments. Having one interface eliminates the need to look in numerous systems, memorize the information and determine if the actions are all optimally coordinated. A centralized command, control, communication and intelligence system is used to coordinate the many complex activities required to deploy troops, supply the forces and execute attacks. They also need a “smart” system that allows users to input business rules and alerts them if a rule is broken. Therefore, when the Army deploys ground troops, the supply chain can guarantee that the appropriate materials arrive at the deployment location when the troops arrive; and the Air Force can ensure that air strikes do not place the advanced Army troops in danger.

Although no lives are on the line at an organization in the hospitality industry, it can use the same principles to coordinate the complex interactions between the areas that create demand, including revenue optimization, pricing, distribution, customer relationship management and marketing departments. All of these functions need to be aligned to a common profit optimization goal, which might change daily or hourly. There are significant profitability advantages from a system that automatically tracks demand forecasts, customer interactions, channel availability, promotions and pricing initiatives; alerts the users when they are out of alignment or when unusual or relevant events occur; and reports off one centralized database.

For example, the revenue management system forecasts low demand for garden-view rooms at a luxury beach resort in the Caribbean in January. Marketing and CRM systems are automatically alerted to develop a promotion to stimulate demand during this time. The marketing system searches for promotions that maximize expected response rates while minimizing costs. Simultaneously, the CRM system searches for customers that fit the target profile likely to respond to this offer - considering not only their product preferences (garden-view rooms), past purchases and tier status, but also their visit frequency and whether they are “due” for another visit. The promotion is generated, and alerts are sent to the marketing and CRM managers for review and approval. The promotion is launched, encouraging bookings through channels that minimize booking costs while reaching the appropriate customers. Customers appreciate the one-to-one nature of the communication, increasing their loyalty and generating additional demand for the property.

This level of integration requires a foundation that not only includes data integration and storage, but also complex advanced analytics such as forecasting and optimization. The true total demand profit optimization system must be able to predict and take actions on demand levels, determine the optimal mix of products and prices that should be offered, and predict which customers are most likely to buy this profitable mix of products (including which channels will be used for purchase).These decisions are made in advance so that the organization is constantly taking action rather than reacting to fluctuations in demand.

Successful total demand profit optimization implementations
Total demand profit optimization involves even more data than the already data intensive revenue management systems, requiring interfaces with multiple systems and a data warehouse with the capability to store and access large volumes of data. Customer information is notoriously “dirty,” and may contain missing data, nicknames or initials, and have the same person listed under multiple addresses. Ensuring credible data requires powerful data quality and data cleansing algorithms, as well business processes that encourage customers to provide rich information that gets accurately captured. Finally, the intensive analytical requirements and need for practically real-time information demand a database that stores data in a manner that allows it to be quickly and easily accessed and processed.

The heart of any revenue management system is forecasting. Research has shown that a 10 percent increase in forecast accuracy results in a two percent increase in the bottom line. The forecasting engines must be able to forecast accurately at a very detailed level. For some firms, forecasting demand for each individual room type from each individual market segment over the entire forecasting horizon (which could be many months or years in the future) requires the forecasting engine to perform millions of forecasts within a reasonable amount of time. All of these individual forecasts must then be fed into an optimization engine that establishes controls to ensure that the most profitable mix of customers, room types and prices are offered on each day in the booking horizon. In addition, the optimization engine establishes the optimal levels of overbooking to protect the hotel from no-shows and cancellations.This forecast drives all of the decisions in the total demand profit optimization system. In addition to the forecasting and optimization requirements, advanced statistical processes to segment customers, predict their response rates and calculate their willingness to pay for pricing decisions are also required for integrated total demand profit optimization.

An extensive cultural change within the organization is required for successful total demand profit optimization implementations. Goals and incentives must be aligned so that the entire organization is operating toward total demand profit optimization in unison, rather than on a departmental basis. Existing transactional systems may need to be integrated, and customer-facing personnel retrained to manage interactions according to total demand profit optimization goals. The move toward total demand profit optimization is complex and challenging, but the rewards of centralizing and automating revenue-generating processes are great.